Suppose people are betting on the outcome of a future event. For example:
- Outcome A: The price of oil will be greater than or equal to \$100 per barrel on 31st December 2020.
- Outcome B: outcome A will not occur (i.e. price will be less than \$100).
From my understanding, parimutuel betting works like this:
- On any day before 31st December 2020, those who believe in A will bet any amount they please. Similarly for those who believe in B.
- Suppose that on 31st December 2020, the total bets on A is \$1000, and the total bets on B is \$800. Suppose that outcome A occurred (i.e. the price of oil is >\$100).
- The bets on A and B are summed together (\$1800). This pool of \$1800 is then redistributed to those who bet on A, in proportion to the amount they initially bet. (e.g. if I bet $100 on A, my bet accounts for 10% of the total bets on A, so I am entitled to 10% of the total pool: \$180).
My questions are:
- Doesn't this system give an advantage to those who placed their bets at the very last minute (e.g. on 30th December 2020) because the likely price on the end date is known? The people who placed bets at the last minute seem to have an information advantage over those who placed their bets early.
- If so, what are the incentives used to make bettors place their bets early (e.g. in January)?
In the financial world, I can wager on outcomes using options. Option prices consist of intrinsic value and time value. The further the expiration date is, the higher the time value. The time value is the compensation for the risk taken for wagering early. No such "time value" appears to exist with parimutuel betting.
Best Answer
This is a well known problem of parimutual betting: It is foolish to place bets early. Not only can circumstances change before betting closes---which means that you might have made a different bet with the new information---but you also reveal you information by betting early and aggressively, which makes the odds shift. One paper in game theory and information economics therefore argues that rational and strategic bettors should only place their bets at the last possible moment:
The solution is to use something called prediction markets. Here, one does not simply pay into a pool and the money gets divided among the winners after resolution of the outcome. Rather, you buy assets whose prices evolve over time. Here, you do have incentives to buy early if you have some good information, because early prices may be "off", and you can sell later at a profit when prices have moved to more reasonable levels.